One of the most important decisions you make when you buy life insurance is determining who to make beneficiaries for the benefits of the policy. The policy owner makes this decision. Remember a life insurance policy is a legal contract between the policyholder and the insurer. The insurer agrees to honor the terms of that agreement and pay the proceeds, usually the policy’s death benefit (e.g., $250,000), to the beneficiary named by the policy’s owner upon the insured’s death.
A key point to remember is that this is the insurance company’s only legal obligation, the insured person’s marital, parental or relationship status notwithstanding. The carrier has no say in the beneficiary selection; the selection is the owners to make.
What is a Beneficiary?
If you have a life insurance policy that is current (i.e., premiums are paid up to date), when you die, your insurer will pay out a death benefit (e.g., $250,000). The person or organization you choose to receive that death benefit is called the beneficiary.
The life insurance beneficiary you elect for your policy can be a family member, a friend, a business partner, a charitable organization or a legal entity such as a trust or your estate. While the beneficiary is your choice, some states have laws that regulate who you can name as a beneficiary. These states are the community property states. If you live in one of these states, you should discuss the beneficiary designation with your tax advisor or accountant if you are designating a person other than your spouse as your beneficiary.
Life insurance Death Benefits are Tax Free to the Right Beneficiary
The designation you make is important for tax- and estate-planning purposes also. If you want your beneficiary(s) to get maximum benefit from the financial legacy you leave them, don’t squander the proceeds by making it taxable. Financial experts will advise you to keep the policy’s proceeds out of the probate process. This is done by naming your heirs directly as beneficiaries in the policy because life insurance proceeds receive federal-income-tax-free status when paid to a person. This will also keep the proceeds out of the often time-consuming and costly probate process.
Declaring Primary and Contingent Beneficiaries
Your primary beneficiary is the original person, entity or organization you designate with the insurer to receive the life insurance benefits when you die. Most people designate their spouse. You can also name multiple beneficiaries and determine how much of a stake in the payout each one gets.
If you don’t choose any primary beneficiaries, the insurance company will pay out your benefit to your estate. This can significantly slow down the disbursement of life insurance benefits because your benefits are usually subject to probate, which is when the courts determine who should get your assets. You may also have to pay estate taxes on your life insurance benefit if it goes to your estate depending on the size of the estate and your state of residence.
You’ll also want to choose some contingent beneficiaries. A contingent beneficiary is someone you elect to receive the death benefit if the primary beneficiary dies or goes out of business before you die. Although the contingent beneficiary is named in the life insurance policy, they won’t receive a portion of the death benefit if any of the primary beneficiaries are still alive. The first contingent beneficiary you name is called the secondary beneficiary, the third is the tertiary beneficiary, and so on.
Who Can be a Beneficiary?
The following are people or entities that can be a beneficiary:
Spouse or domestic partner
Children. Naming your children as beneficiaries if they’re still minors can create problems. If you want to do this, be careful and consider the use of a court-appointed guardian or trusts to manage the money until the child reaches adulthood or later (age twenty-five or thirty).
Nonrelatives. You can designate a business partner or even just a friend as a beneficiary. Remember, your beneficiary can be anyone you want, with one exception: If you live in a community property state, you likely will need to get consent from your spouse in order to pay the benefit to someone else.
Organizations. Your beneficiary doesn’t have to be a person. You can direct your life insurance policy to pay out to an organization, such as your business. Many people select an organization as their beneficiary if their family is already well off. A sudden injection of cash can help any business manage the loss of an employee or owner.
Charities or nonprofits. These organizations need contributions, as we all know, and you can help further the cause of your favorite charity, church, or educational organization by naming one as a beneficiary of your life insurance policy.
A trust. Another way to leave an insurance benefit to your intended beneficiary is by having the insurance company pay out to a trust. The most common reason people use trusts is to control access to life insurance proceeds. Trusts are also useful because if you’re considering an unusual choice as your beneficiary, you might run into resistance from the insurer itself. In that case, you can name a trust as your beneficiary so that an appointed conservator can receive and disburse the money on your behalf. There are multiple types of trusts, like irrevocable and revocable living trusts, and you might not even need one depending on what assets you have and what’s in your will.
Revocable and Irrevocable Life Insurance Beneficiaries
There are two classes of beneficiaries known as revocable and irrevocable beneficiaries.
Revocable beneficiaries. The owner of the life insurance policy has the right to change the beneficiary designation at any time without the consent of the previously named beneficiary.
Irrevocable beneficiaries. The owner of the life insurance policy cannot change the designation of the beneficiary without the consent of the original beneficiary.
Which is the better choice? Most experts consider that the simplest way is to go with a revocable beneficiary option. There are a number of potentially complicated legal issues that can occur if you opt to go with an irrevocable beneficiary.
Naming Multiple Beneficiaries
If you want to name more than one life insurance beneficiary, there are two approaches you can take. These are stated as follows:
Per stirpes. You can designate your beneficiaries by branches of the family or lineage. This means that the life insurance proceeds are divided equally among the beneficiaries and/or the surviving children of the beneficiaries. Example: You, as the insured, designated your daughters, Lauren and Kat, as beneficiaries. Lauren dies before you do. If you were to pass away next, then Kat would receive 50 percent of the proceeds, and the remaining 50 percent would then be apportioned equally to all of Lauren’s surviving children.
Per capita. Simply put, the proceeds are divided equally among all the beneficiary survivors of the lineage line. Example: Using the above scenario, suppose Lauren had four children and Kat had no children when you, as the insured, passed away. This means that the proceeds would be divided equally between Lauren’s four children and Kat. Since there is a total of five beneficiary survivors, each beneficiary would get one-fifth of the life insurance proceeds.
If you have multiple beneficiaries, it is best to designate that policy’s proceeds be distributed as a percentage rather than a dollar amount. Why? You might buy a $100,000 universal life policy and apportion $50,000 to your two children as beneficiaries. But when you pass away, the policy could be worth $120,000, and the insurance company will have no instructions on how to legally divide up the remaining $20,000. An unfortunate and avoidable legal battle could ensue for the remaining portion of your policy.
Common Sense Considerations
Here are some common-sense matters to consider when making beneficiary designations:
Fully complete the insurer’s paperwork in an accurate manner. This will include having the correct full names, dates of birth, and/or social security numbers for all beneficiaries designated. Be specific with the people or entities that are to benefit from the policy.
Always include a secondary or contingent beneficiary in your policy.
Revisit your life insurance policies at least annually to ensure the beneficiary designations are current. This would include updating specific bequests to new grandchildren if you are leaving them individual amounts for college or other purposes.
If you get divorced or your dependents change, update or amend your policy.
As we noted above, if at all possible, don’t have the beneficiary of your policy be your estate when you have specific family members whom you want to receive the proceeds. If you name your estate as the beneficiary, the proceeds will become entangled in the estate probate and could cause potential tax issues. Your creditors will also be able to place their claims against the estate proceeds. Named beneficiaries get the proceeds of a life insurance death benefit directly.
If you want to leave amounts to minor or underage children, name an adult to oversee the money until they reach a reasonable age. You don’t want to leave $30,000 to an eighteen-year-old and have to worry about the money being spent on video games or a trip to Las Vegas.
Summary
Naming a beneficiary requires thought, careful planning and continued updating. Not properly planning and completing the mandatory paperwork may create legal or tax complications for your beneficiaries. You may deny them the economic benefits for which you have purchased the coverage.
To discover the answers to key questions of buying life insurance and to get more information on the benefits of coverage, check out The FinancialVerse: Today’s Life Insurance — A Protection Tool for Your Future. This book will help you prepare to meet with a financial professional and apply for the life insurance coverage that you need. Order your copy today!
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